What Family Offices Want From Hedge Funds Now

Recently I asked a fund of funds manager, who was scouting to raise money, “where are you investing now?” He replied, “in hedge funds.” I pressed him further: “Are you buying U.S. stocks?” He answered: “I’m looking for investors interested in limited partnerships.”

His answers made me wonder why investors would pick his fund. My mind flashed back. Several years ago, I read an article by marketing expert Bruce Frumerman of New York City firm Frumerman & Nemeth Inc.: “A fund of funds won’t invest if the hedge fund manager cannot clearly explain his strategy,” Frumerman wrote.

Similarly, he continued, if the head of a family office doesn’t understand how a fund invests well enough to repeat its story to friends while they’re out golfing, he won’t invest.

And, a seeder investor won’t risk his money unless he is convinced that the fund manager is capable of managing the business and not just running the fund.

Frumernan made the observations when hedge funds ruled the investment world. It took very little then to persuade investors to park their money in these alternative vehicles. It’s entirely a different ball game today.

Several surveys document investor confidence in the industry has tanked. A study by Dow Jones Wealth Bulletin and The Wall Street Journal Europe found that many investors feel they were poorly served by their advisers and that they are reviewing their relationships their fund managers.

The “After The Crunch” survey of 30 high-net-worth individuals revealed a big loss of trust in incumbent advisers, following damage done to portfolios during the credit crunch.

Meanwhile, the net worth of the rich has dropped by a quarter from its peak of $40 trillion at the end of 2007, according to a Merrill Lynch and Capgemini study.

Two other researchers, Andreas Hackethal and Michalis Haliassos, from the Goethe University Frankfurt and Tullio Jappelli from the University of Naples, analyzed more than five years of data from a German discount brokerage.

The brokerage gave clients the option of managing portfolios on their own or with the help of an independent financial adviser. Hackethal and Haliassos found that clients who used an adviser tended to have lower returns and higher investment risks than those who decided on their own.

How disillusioned investors are with hedge funds was expressed by Michael Sonnenfeldt, who runs Tiger 21, a New York City group that includes many family offices. .

He said in a newspaper interview earlier this year that his members cut their portfolio weightings in hedge funds to 2.8 percent in 2008, against 11 percent the year before. He said it would take a generation for investors to come to terms with their experience.

Given the current state of investor sentiment, persuading investors to return to the volatile landscape of alternative investments is as tough as climbing the Everest. But many fund managers seem light years away from realizing this new reality.

With the world under the shadow of economic malice and investors spooked by Wall Street shocks, how should money managers approach investors now?

“The job of a salesperson or team, whether in-house or third-party marketer, is identifying prospects, making contact, giving face-to-face presentations and managing follow up throughout the selling cycle for turning prospects into investors,” Frumernan advised.

That is just part one. The main part is to show convincingly how fund managers will make money for investors. A statement like “I will invest in hedge funds” will not cut it.

Here I want to share an anecdote. Several years ago, a family office manager sent a letter to a Thomson publication editor:

"Our greatest challenge," the family office manager wrote, "is finding professional, competent financial advisors. Our inability to identify such a person is the reason I am contacting you. (I am assuming you have exposure to some of the best and the brightest advisors in the financial services industry.)

"While we have a $3 million investment minimum, we still receive more referrals than we can possibly service in our small boutique firm of just five people. Historically, we have declined to provide service to nine out of ten referrals. It is our intention to continue to throttle our growth and remain small.

"We are seeking someone who can demonstrate the ability to provide professional, competent financial advice. We are open to either hiring such a person or possibly establishing a referral relationship. Would you please provide contact information of anyone for whom you have a high regard who might be interested in exploring a relationship with a firm like ours?

"We've interviewed many brokers and find that they're still basically salespeople. They just don't have the knowledge of taxes, estates or investments our clients require, nor the temperament. We don't need an accountant or an estate attorney - we use outside experts. We just need someone who thoroughly understands those areas, can really listen to clients and wants to serve them without selling; we have more business than we can handle."

Precisely speaking, what are the priorities of family offices right now? A survey of 162 family offices worldwide by the Wharton Global Family Alliance found that monetary concerns to be No. 1. “Essentially, what is rated as most important is wealth management,” noted professor Raffi Amit.

Going forward, what money managers will need to do is venture of Wall Street’s four walls and dig deeper to discover bright return prospects. They must find real companies with real products that satisfy real needs.

Also, transparency is the loudest cry of the day. High-net-worth clients now want more information about how their holdings are being transacted, processed and managed. Private clients are looking for answers about the integrity surrounding their wealth and personal data.

Undoubtedly, things will get better. No one knows how soon. But one thing seems certain – investment business has entered a new world. Detroit, Wall Street and Silicon Valley will remain frozen for quite some time - hardly anybody thinks they ever regain their glorious luster.